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There
was a time, not so long ago, when both Indian policy
makers and a significant section of the Indian public
viewed large capital inflows into the country as inevitably
positive, providing much-needed additions to domestic
investment. They also viewed consequent increases in
the exchange rate almost as a badge of honour, a sign
of economic strength.
Of course such a position always had its detractors,
especially among those who realised that what matters
is the use to which capital inflows are put relative
to their costs to the economy, which would determine
their actual impact. Similarly, more sane analysts have
generally noted that a rising rupee is generally positive
only from a simplistic macho perspective, since it would
adversely affect domestic producers of both export goods
and import substitutes. It could thereby even reduce
any positive impact of more external resources available
for domestic investment.
The period of unqualified celebration of capital inflows
appears to be over. Now it appears that even the central
government, which has so far gone out of its way to
attract capital inflows of all varieties, has realised
that it may not all be manna from heaven for the domestic
economy, that it can create tendencies which adversely
affect domestic production and employment, and that
it can even be fiscally expensive.
Of course, it has taken them some time to realise this.
In the last few years India has become a favoured destination
not only for those seeking to create or expand production
facilities, but even more for those engaged in speculative
investments at the international level. As a result,
India is now experiencing an unprecedented surge in
capital inflows.
In recent years, the trade deficit has grown as demand
for imports has expanded rapidly. But the current account
deficit on India's balance of payments has remained
almost constant in 2005-06 and 2006-07 at just above
$9 billion, largely because there have been very large
inflows of remittances from Indian workers abroad, in
oil-exporting countries and in the US. But in this period
two years net capital flows into the country have nearly
doubled from the already high level of $23 billion in
2005-06 to $45 billion in 2006-07.
And this tendency has intensified in recent months,
such that the current year already marks all-time highs
of capital inflows. Net inflows of foreign institutional
investments into India's stock and debt markets start
to rise significantly in 2003, and averaged just under
$9 billion a year during 2003 to 2006. But in the first
ten months of 2007, it has exploded to reach $18.6 billion.
It is this which has driven the Sensex and other stock
market indicators to crazy levels, creating illusions
of wealth that briefly made some of our large capitalists
among the richest men in the world as the value of their
personal share holdings shot up.
But the inflow of largely speculative portfolio capital
has been only one part of the recent surge. This has
also been a period when Indian corporates have been
exploiting the recently liberalised rules for external
commercial borrowing policy and India's currently good
international credit rating to borrow massively from
abroad. This allows them to benefit from much lower
interest rates abroad, but also adds to the country's
external debt, which has suddenly shot up again, this
time led by the private sector. In the period January
to May 2007, external commercial borrowing was as much
as $15.3 billion, compared with $10.8 billion and $3.4
billion during the corresponding periods in 2006 and
2005 respectively.
Note that these are net inflows, and that the gross
inflows have been even higher. The Reserve Bank of India
has liberalising rules governing capital account expenditures
by domestic corporates and residents, and some companies
have taken advantage of this by investing quite substantial
amounts abroad, including in purchasing expensive assets.
Despite this, the massive surge in net capital inflows
has put substantial pressure on the rupee, which has
gone up in nominal value quite a lot vis-à-vis
the struggling US dollar but has also appreciated in
real terms. And this has clearly begun to hurt exporters
of goods and services. Complaints are becoming louder
from the textile and garments industries and from software
exporters, all of whom find it harder to ensure export
orders at rates that will allow them to recoup their
costs. Domestic producers who are adversely affected
by import competition are too diverse to form a strong
lobby, but they too are certainly affected.
Trying to manage this within the liberalised framework
is proving to be a difficult task that is creating all
kinds of paradoxes and further problems. In such a situation,
faced with an unwanted surge of capital that is not
being used for productive investment but is associated
with a rising exchange rate, the obvious thing to do
would be to put some limits and constraints on the capital
inflows.
The most obvious move of all would be, in the first
instance, to reinstate the capital gains tax in the
stock market, which would act as a dampener on unwanted
capital flows and bring in much-needed revenues into
the government's coffers. Other forms of flexible capital
controls could easily be devised that would prevent
undesired inflows without impacting upon domestic investment.
However, the current ruling ideology does not allow
for such creative thinking, and instead insists upon
not just maintaining the existing liberalised rules
but relaxing them further to allow international and
domestic investors unregulated free play. This means
that the only instrument in the hands of the hapless
central bank to prevent excessive rupee appreciation
is direct market activity. Over the past few years,
the Reserve Bank of India has been buying up foreign
currency and expanding its reserve of foreign assets
to adjust domestic demand for foreign currency to the
autonomously driven inflow of foreign exchange.
As a result, foreign exchange reserves have gone up
dramatically, from $76 billion in March 2003, to $152
billion in March 2006 and $199 billion in March 2007.
The rise in reserves continues apace even now – in early
November the value of the reserves was $266.5 billion.
But such holding of reserves is not costless for the
government. Under the Market Stabilization Scheme launched
in April 2004, the Reserve Bank of India is permitted
to issue government securities to conduct sterilization
operations, the timing, volume, tenure and terms of
which are at its discretion. The ceiling on the maximum
amount of such securities that can be outstanding at
any given point in time is decided periodically through
consultations between the RBI and the government.
As far as the central government is concerned, while
these securities are a capital liability, its "deposits"
with the central bank are an asset, implying that the
issue of these securities does not make any net difference
to its capital account and does not contribute to the
fiscal deficit. However, the interest payable on these
securities has to be met by the central government and
appears in the budget as a part of the aggregate interest
burden.
When the scheme was launched in 2004, the ceiling on
the outstanding obligations under the scheme was set
at Rs. 60,000 crore. Over time, this ceiling has been
increased to cope with rising inflows. On August 8 it
was increased to Rs. 150,000 crore for the fiscal year
2007-08. But it had to be raised again to Rs.2,50,000
crore on November 7, with the proviso that the ceiling
will be reviewed in future when the sum outstanding
(then placed at Rs 185,100 crore) touches Rs.2,35,000
crore. It is only too evident that the capital surge
has resulted in a sharp increase in recourse to the
scheme within a very short period of time.
And as this scheme is used more and more, it results
in larger interest burden of the central government,
for funds which it cannot actually use! One current
estimate places the interest cost to the central government
at Rs. 12,400 crore for this financial year, at the
current level of the scheme. It would obviously be more
if the scheme is expanded. And this is only the straight
fiscal cost – it still leaves out the broader cost to
the economy of allowing external commercial borrowing
by companies at much higher interest rates than are
received by the RBI for its reserves held as safe assets
abroad.
So the country is paying heavily for the dubious privilege
of receiving capital flows which it is not using, and
which carry the potential of possible destabilisation
in future at the hint of any financial crisis. Is any
more evidence required of the irrationality of our current
economic strategy?
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